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Fraudulent subprime mortgages
The market seems (more or less) competitive on the supply side. So the greater the opportunity for fraud (by lenders), the more lenders will enter the market. This will bid down prices (interest rates on loans). The loan contract will move toward lower price, lower quality. Of course prices are lower on average but for those who end up ripped off the real price, ex post, is much higher.
On average who loses from such a shift? Well, to some extent there is a pooling of heterogeneous tastes into a single market segment. The ones who don't like the lower price, lower quality equilibrium will be the higher valuation buyers for the contract, that is the wealthier people in the relevant loan class, not the poorer people. The poorer buyers in the market segment might well be better off.
This result does not require buyers to be wary about fraud. It is even possible to get a superior outcome if buyers are totally unaware of prospects for fraud. To the extent buyers are suspicious, they will invest resources in monitoring the behavior of suppliers. Often such monitoring is simply keeping/capturing pecuniary externalities, and thus it is oversupplied relative to a first best. If buyers are fully unaware there will be no socially wasteful monitoring and the lower prices still will arrive.
You might say "Ah, but we cannot dismiss pecuniary externalities when insurance markets are incomplete." I might say "Ah, but aren't buyers generally risk-loving in terms of prices"?
The bottom line is this: whenever you see fraud, apply tax incidence analysis to understand the final results.
Posted by Tyler Cowen on July 23, 2007 at 06:58 AM in Economics | Permalink
Comments
"Risk loving in terms of price"? I see no evidence of this. People get very upset
when the price of their house goes down. It may look like they love risk in an
environment where prices are mostly moving sharply upwards. Certainly people are
willing to bear some greater risk to buy a house whose expected rate of appreciation
is 20% per year than 2% per year. But that is not the same as being risk loving.
Posted by: Barkley Rosser at Jul 23, 2007 7:59:24 AM
Who are your buyers and sellers? Are you talking about fraud by lenders who don't fully disclose terms? Or by people who use identify theft and inflated appraisals to defraud lenders? Or lenders who don't perform the minimum credit checks before reselling loans in the secondary market?
assuming the first case, "prices" == interest rates on loans, and buyers ARE risk loving, since there are ample opportunities to refinance when interest rates change.
Posted by: DK at Jul 23, 2007 8:47:24 AM
Fraud by lenders who don't disclose terms...
Posted by: Tyler Cowen at Jul 23, 2007 8:55:16 AM
Buyers are not "risk loving in terms of prices" in the sense relevent here. Yes, mortgage buyers like volatility in disclosed interest rates, so they can seek refinance opportunities. But Tyler hasn't presented an argument that fraud increases that. What fraud clearly increases is undisclosed interest rate volatility, i.e. the chance you will get an interest rate much higher than you thought you were getting. There is no corresponding upside risk, i.e. no chance you will get an interest rate much lower than you thought you were getting. Buyers do not love that kind of risk. Indeed, given the well-documented fact of strong loss-aversion, there is every reason to believe a known interest rate would be preferable to a 90% chance of a lower interest rate and a 10% chance of a much higher interest rate constructed in such a way that the average is the same as the known rate.
Posted by: David Wright at Jul 23, 2007 12:59:14 PM
Buyers are not "risk loving in terms of prices" in the sense relevent here. Yes, mortgage buyers like volatility in disclosed interest rates, so they can seek refinance opportunities. But Tyler hasn't presented an argument that fraud increases that. What fraud clearly increases is undisclosed interest rate volatility, i.e. the chance you will get an interest rate much higher than you thought you were getting. There is no corresponding upside risk, i.e. no chance you will get an interest rate much lower than you thought you were getting. Buyers do not love that kind of risk. Indeed, given the well-documented fact of strong loss-aversion, there is every reason to believe a known interest rate would be preferable to a 90% chance of a lower interest rate and a 10% chance of a much higher interest rate constructed in such a way that the average is the same as the known rate.
Posted by: David Wright at Jul 23, 2007 1:00:53 PM
Actually, carrying this anaysis further, you could argue that mortgage buyers should prefer the 90%-10% case, because if they land in the defrauded 10% category they can just refinance to have another go at landing in the 90% category. But...
1. Loss aversion is strong enough that they probably still don't prefer it, even though they "should."
2. Particularly in the sub-prime market, lenders have taken pains to protect themselves against such refinancings, e.g. pre-payment penalties and contractual limits on pre-payment.
3. Buyers know that they don't face the same ex post odds of ending up in the defrauded category: if you are defrauded once, it probably means you are a more easily defrauded than the average person, and hence more likely to be defrauded again.
Posted by: David Wright at Jul 23, 2007 1:11:00 PM
Tyler - your analysis is not far off but you have the market participants backward. The
consumer/homebuyer/borrower got a fat package of disclosure documents stating what payments were
required and any resets imposed by the loan. Admit they didn't spreadsheet this out but the borrowers
generally were given the idea from the broker that the rate would change down the road and they should expect to refi (=more business to the broker).
Now remember the offer that homebuyer/borrowers were being given. They need shelter. If you rent
an apartment you must put up a security deposit, first/last month rent and if you dont pay by the
10th you will be on the sidewalk by the 15th. They were given the opportunity to buy a house with
no money down and the closing costs rolled into the loan. They were given a FREE OPTION on the
upside in home prices. No surprise that the strike got over fair value there. Plus look at their
downside vs. rent. If you NEVER make a payment on the mortgage it will take around a year before
you get tossed (yes the time varies by state). Again, they had NO investment in the home.
So buying a home with 2006 subprime terms was better than rent both to the upside and downside.
And these are subprime credits. Which means that by and large they are people who have in the
past stiffed their creditors -- and were rewarded for this with these terms on buying a house.
So yes there was massive fraud going on. But it was the loan buyers (i.e. investors) who were
defrauded not the borrowers. Typically the first mortgage was done at 80% purchase price and a
second mortgage for the remaining 20% -- and the second was not disclosed to the investors in the
first mortgage. They just saw an 80% LTV purchase money first mortgage. Later, the existence of
the seconds were disclosed but only on an aggregate basis. The SEC generally prevented disclosure
of loan level info -- in the interest of protecting investors!
The interest of the lenders/investors in credit here was generally ceded to the rating agencies, who have
in fact resorted to the "we wuz fooled" defense as to why they now expect AAA securities to default
as a result of this.
Posted by: mkl at Jul 23, 2007 3:38:26 PM
"So the greater the opportunity for fraud (by lenders), the more lenders will enter the market. This will bid down prices (interest rates on loans)."
Glad to have discovered your blog. The issue I have with the above is that the frenzy created by all the laxity in lending is 1) not limited to subprime 2) There is no way to compare apples to apples (loans to loans) between lenders unless you submit complete loan packages to different lenders yourself and then compare the ultimate loan docs you receive for signature. Alternatively you can use a professional, ethical broker to do this for you if you lack the assistance of a cpa and attorney. You're playing into the same thinking as the typical consumer that "shops" for their loans. What you see is generally *not* what you get, and this prevents the bid-down. People view loans as widgets, but they're not, at least not now.
Typically, a good broker will price out a loan using wholesale rate sheets or online pricing engines, having all the borrower's information in front of them. They might see a difference of 1/8th to 1/4% in comparable loan programs, but might decide to go with the slightly higher rate because the overall lender fees are lower or the particular lender is a proven performer that does not overload the borrower with silly conditions that derail or delay the loan.
If the borrower goes direct to lender, they are paying retail. If the borrower uses an "upfront mortgage broker" (tm) then they get the true wholesale par rate from the selected lender and can decide effectively if it's worth it for them to pay a higher rate to cover closing costs, or a lower rate by paying discount points. This is what is so misunderstood even today in the lending world... both residential and commercial.
If so inclined, could you pop over to the La Land blog and weigh in on the way census data is used to establish median household income and let me know if I'm off base on this...
Best, Wm
Posted by: William at Jul 24, 2007 6:59:26 AM
Tyler,
Is there a lot of evidence of lenders who did not disclose terms? I think the problem is that borrowers never bothered to read the terms since to them it felt like they were getting free money.
There is definately evidence of fraud in inflated appraisals (but don't have a source handy).
Posted by: Patinator at Jul 24, 2007 11:39:04 AM
The ultimate purchasers of the loans didn't stop to analyse how the legal changes in the resale market had suddenly removed any incentive for the initial "lenders" (now really more like scouts than investors) to vet homebuyers. Largely, although not exclusively, the large investment institutions who were hurt when the music stop "fooled themselves." Or rather their hirelings profited (in the short term at least) from self-deception or a lack of "fiduciary curiosity", to coin a term - while the firms who paid these bozos their bonuses lost an far bigger pile of money.
What's most interesting is the parallel between the functionaries who ultimately stuck their investment firms with these loans and the similar functionaries in accounting and stock-sales firms who fully cooperated with Enron frauds with similarly disastrous results (see the film "The Smartest Guys in the Room.") Again and again, decade after decade, now; the big money seems to be in making "Dutch Book" between the interests of large financial institutions, and that of their higher-level managerial staff, who turn out to be very willing to betray the long-term interests of their employers. Bonus structures focused on the short-term obviously exacerbate those differences (conflicts of interest!), which are already extremely problematic for ordinary stockholders.
CompleteConfusion.com
PS - what does it say about our society that your spell checker has never heard of the word "analyse"? No wonder there's a problem.
Posted by: Russell Johnston at Jul 25, 2007 1:07:28 PM
In my opinion market really need harder regulation for morgage companies to prevent that these will sold any more loans to people who are not qualified. I have read that now the bad loans are threating the entire economy. I don't want to create a mountain out of a molehill, but the situation seems to be really bad. According to some real estate experts the number of foreclosure auctions will doubble in 2008. So there are not many reasons for being optimistic.
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